$A’s limited upside suggests good time to consider global diversification
The failure of the $A to sustain higher levels last week in the face of two pieces of market supportive news highlights its upside from here seems limited. The $A’s far greater downside risk suggests it’s a good time for investors to diversify into foreign markets and currencies.
Two pieces of news momentarily pushed the $A higher this past week: a higher than expected June quarter consumer price index result, and strong Chinese manufacturing data.
On Wednesday, the $A had pushed up to an eight-month high of US95c, compared with just over US94c a week ago. But the $A has since fallen back to $US94c. Due to valuation concerns, it seems few traders want to hold the $A much beyond current levels.
Despite this week’s currency supportive news, however, recent market action affirms our view that the $A is near the top of its likely range for the next year or so – with much more downside than upside risk from here.
In fact, despite continued market confidence in the currency, our view remains that the $A is seriously overvalued – especially given the still weak medium-term outlook for export commodity prices. This is also the view of both Reserve Bank and Federal Treasury officials.
How overvalued is the A$?
Using one of the Reserve Bank of Australia’s most preferred – and publically revealed – valuation methodologies , our estimates suggest the $A is now around 16% over valued, or close to the highest levels of overvaluation in the post-float period. Given the current level of the terms of trade and relative interest rates, the $A should ideally be trading closer to US82c.
Commodity prices to fall
The good news for trade-exposed sectors – though somewhat more mixed news for miners – is that commodity prices are expected to fall further in coming years, as global supply ramps up while Chinese demand slows.
In a Working Paper released in May – which underpinned budget-time economic forecasts – the Federal Treasury conducted a careful study of likely supply and demand trends in the coal and iron ore markets over the coming decade. Based on this analysis, the Treasury prudently projected a further 20% decline in the terms of trade over the six-years to the June quarter 2020.
Based on past relationships between the terms of trade and the real exchange rate, that would in turn be consistent with a decline in the $A to around US70c by June 2020, or 25% below current levels.
Such a currency decline, were it to eventuate, would greatly assist the economy in “re-balancing” back toward non-mining trade sectors as the stimulus from high commodity prices waned. It could also, however, add to price pressures and goad the RBA into eventually increasing interest rates – challenging the current popularity of housing investments and bank shares.
Foreign exposure – a potential hedge against $A weakness
If the $A were to decline in line with the predicted fall in commodity prices, however, it implies investors could boost $A returns by investing in offshore markets – the US in particular.
Indeed, if the $A declined from US95c to US70c over the next six years, investors would be 36% better off (a 5 per cent annualised return) by investing in US financial assets over this period – even before considering the underlying returns (such as interest income, capital gains or dividends) from the assets they invest in.
BetaShares Currency ETFs
With the continued product development in ASX exchange traded funds, it has never been easier for retail investors to gain exposure to offshore markets. For those investors wanting exposure to the greenback, for example, BetaShares offers a US dollar ETF (ASX Code USD).
This fund aims to track the change in price of the United States dollar relative to the Australian dollar. For example, if the US dollar goes up by 10% against the $A (i.e. the $A falls in value) the ETF is designed to go up 10% also (before fees and expenses).